Buybacks are back in vogue and stocks will feel the effect

ONE of the few miracles of this recession is just how well corporate balance sheets have held up. While economic growth has chugged back to life, firms have paid down debt and boosted their cash reserves.

So the question is, what will companies do with all of this extra cash? Well, they have already increased dividends – the average dividend yield for 50 of the top dividend payers in the FTSE 100 is 4 per cent. Now analysts expect a wave of share buybacks. This is good for spread betters as share buybacks can help a stock price to bounce. “After essentially being on hold for the last two years, a number of companies have begun buying back their shares,” says Jeremy Batstone-Carr, director of research at Charles Stanley, the stockbroker. “In this uncertain economic environment companies don’t want to invest their cash in plant and equipment, instead they want to buy back their own shares and boost earnings growth.”

Buybacks have already exceeded $65bn since the start of the year and companies such as Domino’s Pizza, Yahoo, Pepsi and AstraZeneca have either stated plans to buy back shares or have done so already. Two weeks ago, Carrefour, the French supermarket group, announced that it was planning on buying back €1.6bn of its shares (6 per cent of its entire share capital) after a 5.5 per cent boost to sales in the first quarter of this year relative to the first quarter of 2009.

The sectors likely to see buybacks are those which generate a lot of cash such as pharmaceuticals, tobacco and telecoms, says Batstone-Carr. “These are all defensive sectors. The market recovery since last March has been fuelled largely by more cyclical sectors, but if defensive sectors embark on share buyback programmes then this could re-balance the market and investors would pay a premium to buy these shares.”

So what is the benefit of a share buyback for investors? When a company buys back its own shares this boosts earnings per share (EPS). This is calculated by dividing earnings after tax by the number of shares in the company. Obviously, if the number of shares falls, then EPS rises. A higher EPS is attractive for investors because of two things: firstly it measures how efficiently a company uses its capital, and secondly it can boost the share price.

When Carrefour announced their plans for a share buy back on 15 April its share price immediately bounced. Even more interestingly, the volume of Carrefour shares also spiked. Nearly 8m shares were traded compared to the average of about 2m shares per day (see chart).

But opportunities for spread betters can be less fleeting. Share buybacks can occur because a company believes that its shares are undervalued and there is more upside to come. “The last time I remember share buybacks happening a lot was after the dot com crisis,” says David Jones from IG Index. “The economy was weak and shares were looking cheap.”

Jones says that buybacks should be part of an overall trading strategy: “I wouldn’t rely on share buybacks in isolation, but if a company is doing well and its share price is going up then a share buyback is a positive thing.”